Claims analysis, inflation and discounting (part 1)

I’ve had the privilege to straddle life insurance and non-life insurance (P&C, general, short term insurance, take your pick of terms) in my career. On balance, I think having significant exposure to both has increased my knowledge in each rather than lessened the depth of my knowledge in either. I’ve been able to transport concepts and take learnings from one side to the other.

A recent example relates to the common non-life practice of not discounting claims reserves. Solvency II, SAM and IFRS17 moves to require discounting aside, it is still more a common GAAP approach to not discount than to discount claims reserves.

Discounting or fiddling with inflation has some obvious implications for analysing actual vs expected analysis, reserve run offs, and reserve adequacy analysis. That some non-life reserving actuaries trip over because it’s more natural in the life space.

But, first, why are non-life reserves so often not discounted? There are several reasons typically given:

(1) Claim cash flows are too uncertain, therefore it’s not possible to know what term discount rate to apply.

This is mostly a weak reason. In insurance, all cash flows are uncertain to some or other extent. We are discounted expected values with an implied or explicit assumed probability distribution and will usually have some sense of the timing of cash flows. Large claims will cause noise in the analysis of timing and investment returns, but large claims will always cause more noise in the underlying underwriting performance anyway.

There is a link to point #5, which has merit in my mind.

(2) Claim payment periods are usually short, so it doesn’t make a material difference to the result, while increasing complexity.

I’ll consider this combined with #3 below as they are closely related.

(3) Interest rates are low, so it doesn’t make much difference.

Yes, discounting increases complexity. And where the claim development periods are truly short and interest rates are moderate or low, it might not be worth it.

Accounting has “materiality”, Solvency II and SAM have “proportionality” and most actuaries would apply some level of judgement around “significance”. Interestingly, none of these terms is usually well defined or, maybe more concerningly, consistently applied.

However, operating in a range of developing markets with inflation and discount rates anywhere from 3% to 25% means that even fairly short development periods can have a significant impact. The answer surely has to be “perform some quick testing to demonstrate the potential magnitude of the difference to inform a decision” rather than always just ignore it as a rule?

(4) We want to be conservative and this introduces an element of conservatism.

This is an argument I have accepted before, but still isn’t the best way to handle this. If conservatism or profit deferral or market value margins are required, then the magnitude and run-off of these margins should be deliberate rather than arbitrary.

I’ve also seen versions of “We haven’t allowed for ULAE so these two offset, another version where the end result might not be that different but reflects a weak methodology subject to producing materially incorrect results if discounting and ULAE allowances begin to diverge.

(5) Our actual investments need to be extremely liquid given the need to pay out large claims at short notice. Therefore we aren’t able to earn the yield implied by the yield curve. We don’t want to incur strains in future as our assets earn less than the unwind of the liabilities.

As I highlighted in #1 above, this is a real issue. The operational and risk management necessity of maintaining sufficient liquidity, particularly in markets where the instruments used to derive the “risk free yield curve” are not necessarily liquid at all, causes a departure between the rates that theoretically (and naively) should be used to discount and what can actually be reasonably earned on backing assets.

How this issue is dealt with practically is a matter of applicable regulation and standards, professional guidance, past practice and documented policies, the purpose for which the results are being produced, and a good dose of judgement.

(6) A related point to (5) is that insurers don’t want to show interest rate sensitive liabilities, especially when assets are not well matched.

Assets may not be well matched due to bad reasons, but also the need for liquidity, which in certain markets means duration = 0.

In part 2, how discounting and inflation adjusting interact. Part 3 will finally address the AvE, reserve adequacy analysis and impact on P&L.